Source, a European provider of exchange-traded funds, has released a research report examining the expected trends in asset classes and regional growth rates during 2016. The paper also uses scenario analysis to determine the impact that significant events could have on asset prices.

Eurozone equities, especially financials and value stocks are ‘most likely’ to outperform in 2016, according to Source.

According to Source, the most likely outcome for next year is moderate global growth of 3.4% and aggregate low inflation of 3.2%. The research team cites a stabilisation of the European and Chinese economies as support for moderate growth while low commodity prices will keep inflation in check. In this environment, equity ETFs may perform well with an emphasis on European and Japanese exposure due to low interest rate policies. Within sector specific ETFs, those exposed to financials and value stocks are tipped while ETFs tracking growth sectors (e.g. consumer staples, healthcare, and technology) may underperform.

Paul Jackson, Head of Multi-Asset Research at Source, commented: “We place a 40% probability in this base case scenario, but we know from the past that events can often develop unexpectedly to alter the future. In fact, that is almost a certainty.  We therefore consider a range of scenarios and assign probabilities to each one occurring.”

The events that were considered in the research model included the speed and magnitude of interest rate hikes by the Federal Reserve and the Bank of England, the extent of quantitative easing within Europe and Japan, the outcome of the US presidential elections, whether China will experience a hard landing, and whether the UK will exit the European Union.

“We believe that, after the base case, the next most likely outcome is ‘benign deflation’ where there is high growth but deflation. We give this a 25% probability and, interestingly for investors, this should also be positive for equities,” added Jackson.

The worst case scenario, where recession is coupled with deflating prices, has been assigned a probability of 20%. Under these conditions, equity ETFs would underperform while those tracking safe-haven assets (e.g. gold ETFs and sovereign bond ETFs) would benefit.

Investors may wish to hedge their bets by diversifying their portfolio according to the weighted probabilities of the proposed scenarios, thereby avoiding over-concentration in a region or asset class that may underperform. With this combination, the expected return of the portfolio is slightly less than the most likely scenario. Although the probability of a favourable outcome is higher, the potential drawdowns from the negative scenarios are greater than the magnitude of the gains from favourable outcomes.

“A probability weighted approach gives a broadly similar outcome to our central scenario. While we are fully aware of the potential for shocks, we believe investors should continue to benefit from equity exposure in 2016,” said Jackson.